Gear It Up

Ghosts of the crisis are floating through the markets again. MF Global appears to have been 33 to 1 levered according to Ron Barron. The Street was all around the magical 35x when the mortgage market burst. Corzine was playing the game without the underlying bubble asset class. When the history books are written, it will be this fact that stands out. The concept of gearing a sovereign is unique. Some had evaluated the US Treasury note as in a bubble, why not gear that? The trade was a patriotic home run. Corzine will be remembered as the guy who bet the ranch without a bull market, let alone a bubble.

The risk going forward is the heightened concentration of the players. In the last 5 to 8 years, many of us have "gone down the elevator" and partnered up small FI trading shops. These numerous, and mostly unknown, operations are the more traditional players. Managing risk is a priority because its your shop. The bottom line is, the system needs us in the mix. Gearing government securities, as opposed to the headline grabbing equity market, is the activity that is the foundation of economic advance. As Europe shows today, without a functioning, geared bond market the economy (and thus equity) falters.

There is a fine line between stability and an Ice Age (JGBs). Achieving stability by concentrating and regulating participation amongst spectacular (and often criminal) failures is a false victory. The repercussions from this latest debacle will be felt for years.

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One thought on “Gear It Up”

While the term hasn’t been used yet in the press, it seems to me we have another example of a “carry trade” carrying a CEO (and his firm) out the door. Anyone remember super-senior CDO tranches?

If there’s a silver lining in this debacle, it appears to me that the thing that tanked MF was the discipline of MF’s repo counterparties who exacted haircuts and prosecuted aggressive mark-to-markets of the position. (Set aside the notion of whether Repo-to-Maturity on EU sovereign debt is oxymoronic in the first place.) This risk management discipline limited the powder burns of this pain trade to MF itself, and did not cause systemic domino fears.

Of course, there were other indirect victims here, namely MF’s clearing clients. I presume many of these include the folks who, as Kevin points out, rode down the elevator, and created independent trading partnerships. So, add to the list of market risk management these folks engage in continuously the more squishy elements of *non-market* risk management. These would include demanding transparency and performing counterparty risk analyses such that the victory of great performance in TRADING isn’t devoured by the jaws of defeat in failures of SETTLEMENT by the clearing firm.